Can China succeed in defending the yuan?

Money continues to pour out of China. Last month the government spent $100bn of its foreign-exchange reserves trying to prop up the yuan, following December’s monthly record outflow of $108bn. Investors rattled by the economic downturn are fleeing the country, but the government is concerned that if it allows the yuan to fall sharply, it could trigger another round of currency wars – whereby retaliatory devaluations by trading partners would lead to widespread deflation.

This would also greatly increase the cost of servicing the $1.2trn of US dollar-denominated debt held by China’s companies. However, while reserves have fallen to a four-year low, the money spent has achieved little: sentiment remains firmly against the yuan. The central bank, says IHS Global Insight’s Rajiv Biswas, “is caught between the Devil and the deep blue sea”.

But it’s not that bad, argues consultancy Capital Economics. For one thing, the government still has enough reserves to cover another two and a half years of selling at December’s record pace. And China is “better placed than most” to stem the pace of the outflows with the capital controls it already has in place. Because China has only recently begun to liberalise its capital markets, it already has “the infrastructure and regulation” it needs in order to keep a closer eye on money flows.

Capital controls have a mixed record of success in stopping outflows, but if China uses the breathing space they afford to re-establish its central bank’s credibility – by fully implementing the heralded switch from a dollar-focused currency peg to one based on a basket of currencies, for instance – it could then relax the controls “with no ill effects”. An economic recovery, moreover, should help to ease investors’ jitters about a hard landing, which would also reduce outflows.